Month: November 2015

It may come as a surprise to many but according to the Department of Finance the Irish economy is operating well above capacity. The economy’s potential output is determined by the available labour force and the productivity of that labour but output in the economy can be below that potential (a negative output gap, which can be large in a recession) or above it ( a positive output gap, which will lead to inflationary pressures ). The output gap is not observable and estimates can vary widely, particularly for Ireland given that migration has such a significant impact on the labour force, but the official view , from Finance, is that the gap turned positive in 2014 and rose to 2.3% in 2015 with a further increase forecast in 2016, to 2.5%.

The corollary is that unemployment is now deemed to be below the rate consistent with stable inflation, again not a view one often hears articulated from official circles; that unemployment rate ,of 10.3%, compares with the latest actual reading of 8.9%. Consumer prices are flat and Ireland’s Balance of Payments position is not deteriorating, neither of which is consistent with a large positive output gap, but the tightening of the labour market is beginning to have an impact on pay pressures in the economy.

The CSO had just published data on average weekly earnings, showing an annual increase of 2.7% in the third quarter and a more rapid increase of 3.6% for the private sector. The quarterly figures can be volatile but the average rise year to date is also strongly positive, supporting the view that labour is in higher demand , with a resultant upward pressure on earnings as the pool of unemployed workers shrinks.

That demand/ supply balance differs across industries of course and as a result there is a wide variation in earnings growth across sectors. Pay is rising very strongly in some industries, including Transport (5.6%), Information and Communication (4.6%), Administration (7.6%) and Finance (4.0%), while in others the increase is modest , such as Hotels and restaurants (1.9%) and Manufacturing (0.6%). A few are still experiencing falling pay, including Construction (-1.2%) although that sector did experience strong earnings growth in the early years of the recovery.

Price inflation is around zero so the pick up in earnings equates to a strong rise in real incomes, which in turn is likely to support household spending. The consensus forecast envisages further strong employment growth over the next few years and a concomitant fall in unemployment. It will be interesting to see the kind of pay growth that results as a feature of labour markets elsewhere , such as the UK and the US, is that falling unemployment rates have been associated with unusually weak wage growth in this recovery.

The pace at which Irish employment collapsed during the recession surprised everyone, and now the pace of jobs growth is also much more rapid than generally envisaged a few years ago. Seasonally adjusted employment grew by 29k during 2014 and has picked up momentum in 2015, rising by 43k over the first three quarters of this year. That takes the total increase over the past three years to 140k, leaving total employment in the third quarter of 2015 at 1.98 million and 2.9% above the figure a year earlier.

Most industries have seen employment grow over the past year, notably manufacturing (+14k) and construction (+15k), with the latter total now at 127k from a cycle low of 96k, although still a long way from the cyclical peak of 274k. Financial services saw one of the few declines, alongside retail, but the general picture is of an economy in which the growth of domestic spending is translating into robust demand for labour,

The labour force is also responding to the changed environment, and although broadly flat in the third quarter has risen by some 13k over the past year. That was dwarfed by the annual rise in employment (56k) so the numbers unemployed fell by 43k and by a seasonally adjusted 9k in the quarter. That left the total unemployment figure at 197k, the first sub-200k reading since the final quarter of 2008.

The CSO estimated the unemployment rate in q3 at 9.1% , again the lowest in seven years. Moreover, the initial monthly estimated unemployment rate for the quarter had been put at 9.5% and has consequently been revised lower, leaving the October estimate at 8.9% from the initial 9.3%.

The Irish economy , as captured by real GDP, actually bottomed out in the final quarter of 2009 and recent data revisions show that it grew in every subsequent year, albeit marginally in some cases. Yet the general public did not perceive a recovery ,in part due to the absence of employment creation. That has well and truly arrived and the tightening labour market is likely to generate general upward pressure on wages, which is already appearing in certain sectors of the economy.

Economic growth in the euro area (EA) has been trundling along at 0.4% per quarter, which is probably above the zone’s potential rate but has not been strong enough to put much upward pressure on prices; core inflation is likely to average under 1% in 2015 and although some acceleration is generally expected over the next few years it is forecast to be modest. The ECB’s inflation target is set in terms of headline inflation, which is currently lower still, at around zero, and again that is expected to pick up, reflecting the unwinding of the recent falls in commodity prices, but few if any forecast a rebound to 2% or above by end-2017.

Low or zero inflation is supportive of real household incomes given the modest pace of wage growth ( 1.9% in the EA in q2 and 1.8% in Ireland) but the ECB is concerned about a prolonged period of below-target inflation, not least in terms of its own credibility. A more fundamental reason is that the real rate of interest (the nominal rate minus expected inflation) rises if expected inflation falls, which all else equal will dampen investment spending in the economy.

Those concerns have prompted the Governing Council to contemplate further monetary easing, including additional non-standard measures such as an expansion of QE. The latter has helped to boost asset prices in the EA and lowered corporate and bond yields, according to the ECB, but it is less clear what impact that has on inflation- the effect on demand in the economy may not be large enough to put significant upward pressure on prices. QE is also deemed to weaken the currency and the euro certainly fell sharply in the early months of 2015, declining by 11% in effective terms to mid-April. According to the ECB’s models, a 5% depreciation could boost inflation by up to 0.5 percentage points so a currency depreciation would seem to have the biggest impact on prices.

The euro reversed course over the summer months, however, rising by 7% in the four months to end-August , but has started to fall again and is currently about 7% below its value a year ago, albeit still 2.5% above its April lows. This also reflects the expectation of rising rates in the US but the ECB may well seek to precipitate a much steeper fall in the effective exchange rate.

To that end the ECB has flagged a possible cut in its Deposit rate, which for over a year has been at -0.2%. Despite that, deposits at the ECB, which had been very low at the beginning of the year, have risen strongly of late and currently stand at €187bn i.e. banks would prefer to pay to leave cash at the ECB rather than lend it to their peers. Draghi had previously indicated that rates had reached the effective lower bound but that may be reassessed, not least because the deposit rate is at -0.75% in Switzerland and Sweden. Consequently, any Deposit rate cut in early December may be larger than the modest change generally expected and a rate of -0.5% could be on the cards, which would also increase the universe of bonds eligible for QE. Similarly, the refinancing rate could also move to zero or even marginally negative (the Swedish reo rate is -0.35%) if the ECB wants to surprise the markets and engineer a more substantial fall in the exchange rate.

The ECB has flagged the possibility of adjusting its asset purchase programme (QE) to boost economic activity and move inflation closer to target. At the moment the Bank is buying around €60bn of assets a month, with over €50bn in the shape of Government bonds, with the intention of continuing until at least September 2016. One practical concern regarding extending that timeframe is the supply of eligible bonds and that may well become more of an issue in the Irish market as we move through 2016.

The nominal value of Irish Government bonds currently outstanding is €125bn, with some €95bn falling within the maturity range eligible for QE (over 2 years and under 30 years). Bonds yielding below -0.2% are also excluded under the current criteria, which affects a number of countries, notably Germany, but not Ireland. The ECB can buy up to 33% of bonds issued, so that implies an Irish figure of €31bn.

QE started in March and purchases in the Irish market have averaged €0.8bn a month, bringing the total to €6bn at end-October. Plenty of scope left, therefore, except that the ECB and the Irish Central Bank already hold Irish bonds, and that figure is included in the QE calculation. The Central Bank acquired €25bn of bonds as part of the Promissory note deal, with €7bn maturing within 30 years. The ECB’s holdings arose from the Securities Market Program , which operated for a time in 2010, and amounted to €9.7bn at the end of last year. We do not know the current position or how many will mature over the next two years but from the average maturity (4.5 years) it would seem reasonable to assume that €7bn would redeem after 2017 and hence fall within QE eligibility.

On that basis the ECB and the Irish Central Bank may own an additional €14bn of Irish eligible bonds, bringing the total to €20bn when adding the QE purchase to date. Absent any other changes that would mean that the ECB could buy an additional €11bn, which at the current pace of purchase implies a maximum of 14 months, taking us to the end of December 2016 or just three months beyond the current timeframe.

On the face of it, then, the scope for extending Irish QE is very limited, although two factors are likely to give the ECB some leeway, albeit not a great amount. The first is additional supply from the NTMA, with perhaps €10bn issued in 2016, which would boost the eligible bond total by that amount if over 2 years in maturity. That would allow €3.3bn in additional QE , an extension of four months. In addition , the Central Bank is required to sell at least €0.5bn of its bond holding next year and any sales would leave greater room for ECB buying of bonds held by the market. On that basis Dame Street may well sell far more than the minimum.